16 Asymmetric Information

Dr. Smita Sharma

Learning Outcome:

 

After completing this module the students will be able to:

 

Understand the concept of Complete information and Asymmetric Information Understand the main problems associated with Asymmetric Information.

 

Read about the solutions available in economics literature for the problem of Asymmetric Information

 

Asymmetric Information

  1. INTRODUCTION

 

In traditional Microeconomic theory, one main assumption is that of complete information. Every economic agent, be it producer (or seller), consumer (or buyer), worker or manager; is supposed to make a rational choice based on complete information about costs and benefits involved. In reality, economics may neither be complete nor free. Therefore the decisions by economic agents may be based on bonded rationality. Complete information may not be sought (as information is not free). Collecting information about all the alternatives can be uneconomical time-wise too.

 

According to Macmillan dictionary of modern Economics, Asymmetric information implies differences in the information processed by the parties to a market transaction. Buyers and sellers have unequal knowledge of the relevant information. This absence of perfect (or equal) information on the part of buyers and sellers precludes perfect competition. We can give example from economics literature about the first fundamental theorem of welfare economics which states that in a competitive economy with no externalities, prices would adjust so that the allocation of resources would be optimal in the Pareto sense. A key assumption for the theorem to hold is that the characteristics of all products traded on the market should be equally observed by all agents. But when information is asymmetric, prices are distorted and do not achieve optimality in the allocation of resources.

 

Presence of asymmetric information can give rise to a number of outcomes such as adverse selection, Moral hazard or Principal-agent problem.

 

 

II. Adverse Selection

 

First major outcome of asymmetric information can be a phenomenon called as adverse selection as sellers may have access to information that buyers do not have. Example can be health insurance market. The person buying health insurance may choose not to report a health issue, may underreport the extent of his disease while buying insurance or may not reveal information about dangerous jobs or high-risk lifestyles to get life insurance.

  • The phenomenon of adverse selection was mainly explained by Akerlof (1970) in case of second hand car market. If the potential buyers are not able to distinguish between a high-quality car and a low quality car (which in America is known ac “lemon”), they will only willing to pay a fixed price for a car that averages the value of a good car and “lemon” together. But sellers know whether they hold a good car or a bad car. Given the fixed price at which buyers will buy, sellers will sell only when they hold “lemons” and they will leave the market when they hold a high quality car. Eventually, as enough sellers of high quality second hand cars leave the market, the average willingness-to-pay of buyers will decrease (since the average quality of cars on the market decreased), leading to even more sellers of high-quality cars to leave the market through a positive .Therefore Adverse selection is the market mechanism that leads to a market collapse.
  • On thee relevance of studying adverse selection arising out of asymmetric information Akerlof (1970) writes, “This paper relates quality and uncertainty. The existence of goods of many grades poses interesting and important problems for the theory of markets. On the one hand, the interaction of quality differences and uncertainty may explain important institutions of the labour market. On the other hand, this paper presents a struggling attempt to give structure to the statement: “Business in underdeveloped countries is difficult”; in particular, a structure is given for determining the economic costs of dishonesty. Additional applications of the theory include comments on the structure of money markets, on the notion of “insurability,” on the liquidity of durable, and on brand-name goods. There are many markets in which buyers use some market statistic to judge the quality of prospective purchases. In this case there is incentive for sellers to market poor quality merchandise, since the returns for good quality accrue mainly to the entire group whose statistic is affected rather than to the individual seller. As a result there tends to be a reduction in the average quality of goods and also in the size of the market. It should also be perceived that in these markets social and private returns differ, and therefore, in some cases, governmental intervention may increase the welfare of all parties. Or private institutions may arise to take advantage of the potential increases in welfare which can accrue to all parties. By nature, however, these institutions are nonatomistic, and therefore concentrations of power -with ill consequences of their own – can develop”.1 Nonatomistic means institutions or variables which are not comparable. He further elaborates that The Lemons Principle also casts light on the employment of minorities. Employers may refuse to hire members of minority groups for certain types of jobs. This decision may not reflect irrationality or prejudice -but profit maximization. For race may serve as a good statistic for the applicant’s social background, quality of schooling, and general job capabilities.
  • Similarly, a company selling health care insurance has to estimate the level of risk accurately. This is difficult because they will not have complete information on the risk status of the person they are insuring. One solution is to set the premium at an average risk level. But this makes the policy expensive for low risk customers who therefore may choose not to buy the insurance. The process whereby the best risks select themselves out of the insured group is called adverse selection.
  • Insurance companies know that this is likely to happen so they offer different premiums according to the level of risk and the person’s experience of ill health. This is why most companies will offer non-smokers a lower premium than smokers. Offering low insurance premiums to low risk groups, often called ‘cream skimming’ or ‘cherry picking’, means high premiums have to be charged to high risk groups such as the elderly or chronically sick. Therefore, in a free market, health care insurance is likely to be too expensive for many people, and especially for those most in need of health care.
  • Moral Hazard
  1.  Moral hazard can be defined as the possibility of consumers or providers exploiting a benefit system unduly to the disadvantages of other consumers, providers or the financing community as a whole.
  2. Having insurance can change the way in which we act. Our attitudes change by the fact that we have got insurance – this is what is called as moral hazard.
  3. In healthcare market, as doctors have more knowledge and information regarding disease and treatments as compared to their patients, a doctor may choose to overprescribe medicines and clinical tests for commission.
  4. Similarly, in a firm if workers are not being monitored they may choose to shirk work or underperform.

 

  1. PRINCIPAL-AGENT PROBLEM

 

This refers to the situation in the theory of the firm where interests of managers and shareholders differ. The principal (i.e. the stockholder) has interest in the performance of the firm (mainly in terms of profits). The agents (i.e. the managers) acts on behalf of principal and principal may not be able to fully control what the agent does.

  • The traditional Microeconomic theory of firm behavior considers profit maximization to be the sole goal of a firm. In contrast the managerial theories of the firm (or organization) consider the firm to be a coalition.
  • Firm is not owned by a single owner, rather by multiple stockholders. Owners of firm and managers of firm are two different groups. Firm is generally considered to operate in imperfectly competitive market.
  • As information is not complete, uncertainty prevails.
  • This type of assumption about a firm is more realistic. Each group within a firm, be it owners, managers, workers, consumers and suppliers, will have different utility functions. Owners will seek to maximize profits, managers will seek better salaries and power, workers will seek higher wages and better conditions to work, consumers will seek low price but more variety and quality and so on.
  • But out of all these groups, the most important group is considered to be ‘managers’, followed by shareholders and workers. Not only the top management sets the goals of the firm, as the goals may be in conflict with various groups within the firm, top management works towards reconciliation of goals too.
  • As various groups compete with each other for their individual group-specific goals, there is continuous struggle and bargaining within the firm.
  • The decisions by top management are based on bonded rationality. Complete information may not be sought (as information is not free). Collecting information about all the alternatives can be uneconomical time-wise too.
  • As no detailed cost-benefit analysis is undertaken, one can conclude that top management acts in ‘limited’ rational way. Information is generally searched only if some problem is there.
  • The desire of various managers for security and power in the organization leads to position bias. Just to show importance of their demand, they may overstate the requirements and this may eventually lead to an upward bias in the cost structure of the firm.
  • Furthermore, information may be distorted or under-reported.

 

V. SOLUTIONS TO ASYMMETRIC INFORMATION

 

Though gaps in information are inevitable, there are some solutions suggested in economic theory. The main solutions are:

  • Market Signalling

 

The Market signalling model was given by Spence (1973). He explains that in most job markets the employer is not sure of the productivity of an individual at the time he hires him, nor will this information necessarily become available to the employer immediately after hiring. The job may take time to learn. Often specific training is required. And there may be a contract period within which no recontracting is allowed. The fact that it takes time to learn an individual’s productive capabilities means that hiring is an investment decision. The fact that these capabilities are not known beforehand makes the decision one under uncertainty. According to Spence (1973), “To hire someone, then, is frequently to purchase a lottery”. If the employer is risk-neutral, the wage is taken to be the individual’s marginal contribution to the hiring organization. Primary interest attaches to how the employer perceives the lottery, for it is these perceptions that determine the wages he offers to pay. As the employer cannot directly observe the marginal product prior to hiring, he does observe personal data in the form of observable characteristics and attributes of the individual, and it is these that must ultimately determine his assessment of the lottery he is buying. (The image that the individual presents includes education, previous work, race, sex, criminal and service records, and a host of other data.) Of those observable, personal attributes that collectively constitute the image the job applicant presents, some are immutably fixed, while others are alterable. For example, education is something that the individual can invest in at some cost in terms of time and money. On the other hand, race and sex are not generally thought to be alterable. Some attributes, like age, do change, but not at the discretion of the individual. On the basis of previous experience in the market, the employer will have conditional probability assessments over productive capacity given various combinations of signals and indices. At any point of time when confronted with an individual applicant with certain observable attributes, the employer’s subjective assessment of the lottery with which he is confronted is defined by these conditional probability distributions over productivity given the new data. There is not much that the applicant can do about indices. Signals, on the other hand, are alterable and therefore potentially subject to manipulation by the job applicant. Of course, there may be costs of making these adjustments. Education, for example, may be costly. We refer to these costs as signalling costs. Notice that the individual, in acquiring an education, need not think of himself as signalling. He will invest in education if there is sufficient return as defined by the offered wage schedule. Individuals, then, are assumed to select signals so as to maximize the difference between offered wages and signalling costs. A Critical Assumption is that a signal will not effectively distinguish one applicant from another, unless the costs of signalling are negatively correlated with productive capability. For if this condition fails to hold, given the offered wage schedule, everyone will invest in the signal in exactly the same way, so that they cannot be distinguished on the basis of the signal. Signalling costs are to be interpreted broadly to include psychic and other costs, as well as the direct monetary ones2.

 

While Spence (1973) focuses on asymmetric information in labour market and its solution, example of market signalling in product market are guarantees and warranties. Many firms produce consumer goods and the market is highly competitive while the product is diversified. Some brands, to prove their quality and reliability start giving guarantees and warranties. These guarantees and warranties act as signal for consumers that the product is of good quality. The consumers feel that the manufacturer must be sure about the product’s efficient working to take responsibility of repair/exchange.

 

Similarly if an already employed worker wants to signal his commitment level to the employer, he may choose to work overtime or late into night. If he does not give this type of signal, his level of sincerity and commitment may never be noticed.

Similarly the employers may choose to give incentives in form of special awards or certificates of commendation based on employees’ performance, punctuality, regularity etc. The employees will feel that they are being monitored on these indicators hence will choose to give better performance.

 

Another example can be imposing penalty or punishment to offenders. Whatever punishment a caught offender will get, will act as a signal for others. We can take case of income tax evasion. Generally taxes are paid on the basis of self assessment of income by the tax payer. It is extremely uneconomical (both financially as well as time wise) to completely check the details of each and every taxpayer. As there is information gap between the taxpayer and the authorities, problem of asymmetric information arises. So the income tax department may check a number of cases randomly, and if found to be evading taxes or under-reporting income, the evaders can be heavily penalized. This heavy penalty acts as a signal for all tax payers.

  • Efficiency wage Theory

 

This theory proposes that the marginal product of workers and the wages they are paid are inter-related. Therefore, to avoid moral hazard or shirking by employers, firms may pay wages in excess of equilibrium wage i.e. in excess to those that clear the market. A consequence of this will be simultaneous existence of higher wages and unemployment.

 

An interesting example of efficiency wage which is highly cited in microeconomics

textbooks is efficiency wage at Ford motor company3. After 1913 when mechanisation started at Ford Motors Company, job profile of workers changed drastically because now they were supposed to work in assembly lines. This led to drastic rise in turnover rate from 380 percent to 1000 percent in one year only. Henry Ford and his business partner James Couzens decided to increase daily wage to $5. At that time prevailing market wage rate was $2 to $3. This earned Henry Ford lots of publicity which acted as advertisement for company. Furthermore, as Ford had more workers applying, he could hire more productive workers from this available pool. This not only made the workforce stable, the profits of Ford Motors increased from $30 million in 1914 to $60 million in 1916.

 

There are four different versions of efficiency wage theory:

 

i) The shirking model:

 

Firms can induce employees to work efficiently if they pay wages in excess of the opportunity wages (wages prevalent in market, which they can get if not working in this particular firm). This ensures a penalty for poor performance and discouragement to shirking.

 

ii) The turnover Model:

 

The firms pay higher wages to reduce turnover.

 

iii) The Superior job applicant pool:

 

By paying high wages, the firm will attract more high quality, high productivity workers into the pool of applicants and therefore even if they randomly select workers from this pool, they will end up hiring a more productive workforce.

 

iv) The fair wages model:

 

Receiving higher wages satisfy individuals’ demand for fair and more equitable treatment and may produce superior performance in return.

  1. SUMMARY

 

Asymmetric information implies differences in the information processed by the parties to a market transaction. Buyers and sellers have unequal knowledge of the relevant information. Presence of asymmetric information can give rise to a number of outcomes such as adverse selection, Moral hazard or Principal-agent problem. Example of adverse selection can be can be health insurance market and second hand car market. Moral hazard can be defined as the possibility of consumers or providers exploiting a benefit system unduly to the disadvantages of other consumers, providers or the financing community as a whole. Principal-agent problem refers to the situation in the theory of the firm where interests of managers and shareholders differ. Though gaps in information are inevitable, there are some solutions suggested in economic theory. The main solutions available in Economics literature are the Market signalling model and the Efficiency wage Theory.